The Federal Reserve’s April policy meeting featured an in-depth discussion around risks to the economic outlook from falling inflation and current inflation expectations. The central bank’s current policy framework has set a 2 percent inflation target. Meanwhile, core inflation has eased to 1.6 percent, well below the Fed’s target, while inflation expectations remain well-anchored.
Our preferred inflation expectation metrics imply that expectations may adjust downward as the economy moves back toward its long-term trend growth rate of 1.8 percent. This means the Fed has ample room to adjust its policy framework to accommodate the structural shift downward in the pace of growth and inflation over the next two years.
In addition these metrics imply that, if there were to be an exogenous shock to the economy, fiscal policymakers likely have room to inject stimulus into the economy to offset a potential shock without causing a significant disruption of inflation expectations and adding to inflationary risks in the medium to long term.
Let’s look at what is driving lower inflation.
A secular decline in inflation
The economy underwent a structural shift in 1985 due to a change in policy at the Federal Reserve; policy under then-Chairman Paul Volcker, and the coincidental political decline of labor union power, altered inflation dynamics. Within a few years, the emergence of an increasingly globalized economy, and sustained policy focus on inflation, combined to drive inflation down to low levels not witnessed in decades.
Secular stagnation and the need for a flexible inflation target
In the wake of the 2008-2009 financial crisis and the slow recovery and lack of productivity gains left in its wake, the economy entered a period of low growth and damped inflation. Fed policy at the time centered around avoiding a deflationary spiral, and the central bank formally announced a 2 percent inflation target in 2012.
With current interest rates still so low, and with little room for a conventional policy response if the economic recovery stalls, recent conversations are centered on implementing a flexible target.
Survey-based and market-based inflation expectations
Expectations for inflation are important determinants of consumption patterns: inflationary fears are likely to fuel current consumption (i.e., spend now before prices increase), while deflationary fears are likely to damp current consumption (i.e., why spend now when you could spend less later?).
Inflation expectations are generally derived from surveys of market participants or from the relationship between market values of nominal and real interest rates. These carry significant policy implications when the central bank determines rate policy.
We show that market-based break-even inflation estimates based on the 5-year/5-years forward rate are generally more volatile than the Philadelphia Fed’s ATSIX model, survey-based model of inflation estimates.
It could be argued that, in the long-run, survey-based inflation expectations of economists are less-biased indications of inflation trends than implied market-based estimates. As the below figure shows, the trend in expectations data from 1999 appears to offer a mean-reversion target for inflation, with the exception of episodes of positive or negative shocks to the economy (e.g., the run-up to the housing bubble, and the subsequent collapse in economic activity).
In the short run, market-based estimates of inflation expectations can clearly show dependency on the short-run movement in the inflation rate–at least since the Fed announced its 2 percent inflation target, and particularly since mid-2016.
Finally, there has been a shift in inflation expectations that may have grown out of the White House’s tariffs. As the below figure illustrates, the term structure of inflation expectations, which had a “normal” upward-sloped shape at the end of March 2018, is now inverted out to two-years time as expectations of lower growth–and therefore lower inflation–in the next two years takes hold among analysts. To a lesser extent, the expectations curve from 2-years to 10-years also fell relative to March 2018, suggesting lower estimates of moderating longer-term growth.
This is one of the primary reasons why some market analysts are talking openly about deflation. While we do not agree with conjectures of outright deflation, we do believe we will see low inflation persist for some time, which points toward low interest rates and room for fiscal stimulus if needed to boost the economy out of a recession.
The impact of lower inflation expectations on the bond market
As the figure below shows, the bond market appears to be pricing in the impact of lower inflation expectations and lower growth since the Fed’s last rate hike in December 2018. At the front of the curve, 2-year yields have dropped by 35 basis point since Dec. 19, 2018, while 10-year yields have dropped by 20 basis points at the long end of the curve.
Finally, as the figure below indicates, the drop in 10-year yields is likely due to expectations that the Fed’s interest-rate normalization program will be on hold, thereby pushing expectations for short-term rates downward. It may also be due to the downward trend in the term premium built into 10-year yields as investors price in the higher risk of deflation if the recovery were to stall.